What is a Cap Rate?
The capitalization rate (cap rate) is a real estate valuation metric that measures the rate of return on an investment property based on the income it generates. It represents the ratio between a property's net operating income (NOI) and its current market value or purchase price.
Cap rate is expressed as a percentage and provides investors with a quick way to compare the relative value of different investment properties, regardless of their size or price point.
The Cap Rate Formula
Where NOI = Gross Rental Income - Operating Expenses
How to Calculate Cap Rate
Step 1: Calculate Gross Rental Income
Start with the total annual rental income the property generates. This includes all rent payments, parking fees, laundry income, and any other income from the property.
Step 2: Subtract Operating Expenses
Operating expenses include property taxes, insurance, maintenance, property management fees, utilities (if paid by owner), and vacancy allowance. Do NOT include mortgage payments, as NOI measures property performance independent of financing.
Common Operating Expenses
- •Property taxes (1-3% of value annually)
- •Insurance (0.5-1% of value annually)
- •Property management (8-12% of gross rent)
- •Maintenance and repairs (5-10% of gross rent)
- •Vacancy allowance (5-10% of gross rent)
Step 3: Divide by Property Value
Divide the NOI by the property's current market value or purchase price. Multiply by 100 to express as a percentage.
Example Calculation
Purchase Price: $500,000
Annual Gross Rent: $48,000 ($4,000/month)
Operating Expenses: $18,000
NOI = $48,000 - $18,000 = $30,000
Cap Rate = $30,000 ÷ $500,000 = 6.0%
Interpreting Cap Rates
Cap rates vary significantly by property type, location, and market conditions. Here's how to interpret what different cap rates mean:
Low Cap Rate (3-5%)
Lower risk, prime locations, Class A properties. Often found in major metros with strong appreciation potential.
Moderate Cap Rate (5-8%)
Balanced risk/reward. Common for Class B properties in secondary markets or suburban areas.
High Cap Rate (8%+)
Higher risk, Class C properties, or distressed assets. May indicate deferred maintenance or challenging locations.
Important Caveat
A higher cap rate doesn't automatically mean a better investment. Always investigate why a property has an unusually high cap rate before assuming it's a "good deal."
Cap Rates by Property Type
Different property types typically trade at different cap rate ranges due to varying risk profiles and operational complexity:
| Property Type | Typical Cap Rate Range | Notes |
|---|---|---|
| Single Family Rental | 4-8% | Strong appreciation potential |
| Small Multifamily (2-4 units) | 5-9% | Good balance of cash flow and growth |
| Large Multifamily (5+ units) | 5-10% | Economies of scale, more management |
| Retail | 6-10% | Tenant quality matters greatly |
| Industrial | 5-8% | Strong demand, lower maintenance |
Limitations of Cap Rate
While cap rate is essential, it has important limitations:
- 1Ignores financing: Cap rate doesn't account for your loan terms, interest rate, or leverage strategy.
- 2Static snapshot: It reflects current income, not future growth or value-add potential.
- 3Market variations: Comparing cap rates across different markets can be misleading without context.
- 4Quality blind: Two properties with the same cap rate may have vastly different risk profiles.
Always use cap rate alongside other metrics like cash-on-cash return and internal rate of return (IRR) for a complete picture.
Calculate Cap Rates Automatically
Estara AI calculates cap rates, cash-on-cash returns, and risk assessments for every property in your Investor Report.
Get Your Free Snapshot